Tax Reform Part 1: Restructuring & Insolvency Related Provisions - Net Operating Losses
Congress is attempting to pass tax reform legislation and presently the House of Representatives and the Senate have separate proposals under consideration (separately, H.R. 1 and the Senate Plan, respectively, and collectively, “Tax Reform”). The Tax Reform is changing daily, but one thing seems likely and that is that the Tax Reform will change the treatment of net operating losses (“NOLs”). These changes would have the most significant impact to bankruptcy cases filed after December 31, 2017. The changes will also have an immediate, and possibly material, impact to any company with deferred tax assets (“DTAs”).
Under current law, an NOL results when a company’s losses exceed its income in a given year, so that it is in an overall net loss position. Presently, NOLs can be carried forward 20 years and carried back two years to offset any net income and such deduction to income is dollar-for-dollar.
The Tax Reform changes the treatment of NOLs, and in this regard, both H.R. 1 and the Senate Plan are very similar, but there is an important difference with the effective dates for the rules. The Tax Reform limits the use of NOLs to 90% of a company’s taxable income and denies any carryback, but provides for indefinite carryforward (instead of the 20-year limit). Only H.R. 1 provides for an increase in the value of NOL carryforwards by an inflation factor (the short-term AFR, plus 4%).
Although it is less than clear, it appears that H.R. 1 would impose the 90% cap not just to prospective NOLs, but also to NOLs arising before January 1, 2018. While the Senate Plan clearly states that the cap only applies to “losses [NOLs] arising in taxable years beginning after December 31, 2017,” H.R. 1 instead says that the 90% cap applies to “taxable years beginning after December 31, 2017.” Application of the 90% cap to historic NOLs would be significant, and, as discussed below, would materially impact DTAs.
Importantly for distressed companies, the Tax Reform disallows the carryback of NOLs (including the extended 10-year carryback period for specified liability losses (which generally include those losses that arise out of tort litigation, such as for manufacturer defects)). This would apply for NOLs generated after December 31, 2017. This is important because often companies will use the 2-year (or 10-year) carryback of NOLs to generate “quickie refunds” as a way to finance the administration of the bankruptcy case. It usually takes about 90 days to process the refund. This process of financing bankruptcies would no longer be available, except to the extent pre-2018 are used.
The Tax Reform impact on NOLs is also of immediate interest to investors in the debt and equity of companies with DTAs. A DTA reflects the value of a company’s tax attributes that may be used in the future to reduce its tax liability and includes such things as NOLs and credit carryforwards. The value of a company’s DTA is dependent on several factors, including the statutory tax rate, the ability to use the asset and any limitations on the use of the asset. For example, assuming the current tax rate of 35%, if the company has a $100 NOL, no limit on the use of the NOL, and the company has $100 of income in 2018, the value of the NOL is $35, discounted to present value.
As discussed above, the Tax Reform, on a whole, devalues NOLs. Further, the Tax Reform reduces the corporate tax rate from 35% to 20%. Thus, using our simple fact from the example above, under the Senate Plan, the same company’s NOLs would be worth $20, not $35. This difference is substantial to companies with large DTAs. Further, under H.R. 1, the DTA in this example would be worth $18 (($100 x 90%) x 20%). The 90% limit would only apply prospectively under the Senate Plan.
Of course the value of a DTA is contingent on a company’s ability to generate taxable income, so any value of a DTA would have to be properly discounted. The discounting would need to take into account the new limits (and some benefits) on NOLs under the Tax Reform, as discussed above.
As public companies are required to take a valuation allowance for any DTA that does not have a greater than 50% chance of being used, and this calculation considers the ability to generate taxable income, investors should consider the impact of the Tax Reform on the balance sheet of companies with significant DTAs.